Saturday, September 27, 2008

Having considered some basic concerns, let us consider a few areas relating to the 2008 Directions.

Essentially, the requirements are just a few if one groups them. The Auditors are required to report on compliance generally relating to registration. For example, has the NBFC registered itself with the Reserve Bank of India if it is required to do so? The reverse question to be also answered is, does the NBFC holding a Certificate of Registration still an NBFC? And so on.

Then there are reporting requirements relating to eligibility relating to acceptance of deposits and whether the applicable limits to the particular NBFC on deposits have been exceeded.

There are requirements on whether the Directions relating to Prudential Norms have been complied with generally and specifically with regard to certain matters.

Also, whether the specified reporting requirements have also been complied with?

And so on.

These are the reporting requirements for the report to the Board of the NBFC. However, there are two situations under which the Auditors has to make, what is called an “exception report”, directly to the Reserve Bank of India. Firstly, if, in the report to the Board of the NBFC as discussed earlier, there are any statements that are unfavorable or qualified, then the exception report in respect of such statements has to be made. Secondly, if the NBFC has not complied with any of the specified provisions of law relating to NBFCs – a review of the list shows that practically all the provisions under the RBI Act or which the RBI has notified are to be covered – such non-compliance has also to be so reported directly to the Reserve Bank of India.

The Directions has thus put the onus of checking on compliance of all such laws on the Auditors. Auditors normally check on accounting requirements or a few provisions of laws that affect such accounting requirements. The onus placed on the Auditors under these Directions relate to intricate issues of law most of which are not connected with accounting. And these laws are often not clear and have ambiguities. Nevertheless, the Auditors would be obliged to interpret and take a view on them and report to the Reserve Bank of India on non-compliances.

Consider a very basic requirement relating to NBFCs. When is a company an NBFC? The Act gives a fairly convoluted definition but it boils down mainly on what the “principal business” of the company is. What is the “principal business” and how does one decide what is the “principal” business? The law does not give any guidance. The Reserve Bank of India has given some indicative specific requirements under certain circumstances in a press release but one wonders whether it has any legal status. In fact, whether a company is or is not an NBFC is a question that requires consideration of many factors but surprisingly, the Public Deposits Directions state that if there is any doubt as to whether a company is a NBFC or not, the Reserve Bank of India will decide the issue in consultation with the Central Government and its view would be final. But for the purposes of the report, still, the Auditors will have to form his own opinion. Mind you, this question has to be answered not just for NBFCs but for every company because the Auditors have to question every company’s facts as to whether it is an NBFC.

Further, taking a view as to whether a company is an NBFC or not has serious repercussions. If a company is an NBFC and it has not registered, the punishment for non-registration is a minimum and mandatory imprisonment of one year.

Criticisms apart, these Directions do put a check on the NBFC itself. It knows that, though a little later after maybe a year, someone is going to check on compliance of the law by it and if there are non-compliances, there would be a direct report to the Reserve Bank of India.

NBFCs have always been considered to be sensitive entities by the Reserve Bank of India since they can accept deposits from the public without the rigorous discipline applicable to banks. The many investments banks that failed in the US recently are comparable to the NBFCs here despite certain conceptual and legal differences. Even these entities there used Other People’s Money and lost them in trillions of dollars. The loss obviously is not restricted to those who gave monies to such entities but there were system wide – even global - repercussions. In this context, NBFCs in India are obviously bound to face strict regulations and these 2008 Directions are just some more of such controls.

Friday, September 26, 2008

Recently, as briefly referred to an earlier posthere, the Reserve Bank of India has notified the NBFCs Auditors’ Report (Reserve Bank) Directions 2008 (“2008 Directions”) (full text availablehere). These replace similar directions issued exactly a decade back, i.e., in 1998. Both these Directions require auditors of non-banking financial companies (“NBFCs”) to give specific comments regarding the compliance or otherwise of certain provisions applicable to NBFCs. These are to be given in a separate report to the Board of the NBFC. However, if there are any adverse remarks or there is any contravention of the laws applicable to them, as specified, then they have to report also directly to the Reserve Bank of India in what is called an exception report.

The 2008 Directions, however, are much more comprehensive than the 1998 Directions and particularly take into account many of the developments in law notified by Reserve Bank of India itself. It may be recollected that sincethe issue of the Directions relating to Public Deposits and relating to Prudential Norms in 1998, these provisions have undergone major changes. The objective of these 2008 Directions thus appear to update the reporting requirements of the Auditors in tune with these changes and also create certain fresh requirements apart from making some changes in light of experience.

The experience under the 1998 Directions has not been wholly satisfactory maybe due also to ambiguity in the Directions themselves or the provisions they covered.

The coverage of the 1998 Directions was very extensive– they were to examine each and every of the provision relating to NBFCs under the RBI Act and the Directions issued thereunder and check whether these are complied with ornot. This scheme continues even under the 2008 Directions. The provisions of law relating to NBFCs have many areas of ambiguity and controversies and the amendments over the years have not improved the situation. The Directions to Auditors nevertheless require the Auditors to take a call on each such requirement and consider whether these are complied with or not. If they are not complied with, they have to report to the Reserve Bank of India and that too directly. Obviously, though, as a good and fair practice, they would give an opportunity to the NBFC first to give their view.

The 2008 Directions, replacing the 1998 Directions, say that they come into immediate effect. However, clause 2 clarifies that the report required to be given under the Directionsis only in respect of financial years ending on or after the commencement date. In other words, it will apply to the accounts for the year ended 31st March 2009 and NOT to the year ended 31st March 2008. For the year ended 31st March 2008, therefore, the 1998 Directions will continue to apply.

There are many strange aspects to the requirements in the Directions. Consider some of them.

The NBFC itself is not required to report to the Reserve Bank of India of the contraventions. It is the Auditors who haveto report. Of course, the NBFC would be liable for the defaults but it makes sense on creating a requirement to report by the NBFC itself as an early indicator as also an opportunity to the NBFC to present the situation.

The negative report by the Auditors has to be given not to the shareholders, who would be affected by such contraventions, and not even to the depositors who would have serious concerns since non-compliance may be indicative of possible default or at least poor management. The report hasto be given only and directly to the Reserve Bank of India. While on this, note also that the report to the Board is a separate report. There does not seem to be any legal requirement of enclosing this report alongwith the regular Auditors’ report to the shareholders. Of course, there is a possibility that some of the contraventions would be needed to be also reported in the regular report of the Auditors.

The adverse report of theAuditors is quite likely to reach even the Reserve Bank of India after a fairly long time after the contravention. Typically, the company has about 5 months after the yearend to finalise the accounts and audit. Further, even after this period, strangely,no time limit has been given to the Auditors to submit its exception report to the Reserve Bank of India.

Thursday, September 25, 2008

Reserve Bank of India issuedon 24thSeptember 2008 (seehere) certain reporting requirements forcertain non-deposit acceptingnon-banking financial companies (NBFCs). What is important though is that these will be applicable to suchNBFCs of asset size Rs. 50 croresbutless thanRs. 100 crores. Though such entities are not given the status of“Systemically Important”NBFCs, effectively, it is seen that the benchmark or asset size is lowered to Rs. 50 crores though this new category would be exposed to lesserrequirements, at least for now.

Let us consider some background.

Normally,Reserve Bank of India governs only deposit-acceptingnon-banking financial companies (NBFCs). Non-depositingNBFCs have generally been left alone for most purposes after initial registration. However, it wasrealized over a period of time that such non-deposit accepting entities hadbecome relatively large in terms of asset size and their acts, omissions and defaults could have widerrepercussions on the financial markets generally. Thus the concept of“Systemically Important” non-deposit acceptingNBFCs was introduced (also calledND-SI). They were mainly required to give some reports though some substantive requirements were also placed. What is important is that initially theminimumsize ofanNBFC to reach the“Systemically Important” status was Rs. 500 crores. Over a period of timethis limit was gradually lowered and today it stands at Rs. 100 crores.

The latest circular cited above now creates yet anothercategory– no term has apparently yet been given to it– where the asset size isbetweenRs. 50 croresand Rs. 100 crores. Thus, thisrequirement is to catch them early.OncetheNBFCreaches the asset size of Rs. 100 crores,it achievesthe status of“Systemically Important” and would besubject to morecomprehensive requirements.

This newreporting requirement is quarterly and is withimmediate effect, i.e., the first report is to be given for the quarter ended 30th September 2008 though for this first period, the report may be given by the first week of December 2008and thereafter within one month of the end of each quarter. These reports are to be filed electronically but the mechanics of this would be circulated by theReserve Bank of India later on.

The sub-prime crisisistoo fresh in the mindto be even discussed here and the supervision of theReserve Bank of India of non-deposit takingNBFCscan be only viewedin this contextas good conservative measures. The problem though is thatcomplex regulatory requirements are created at times of crisis but continue indefinitelyeven after the crisis passes by.

Wednesday, September 24, 2008

In February this year, the Government (Ministry of Finance) had issued a notification introducing Foreign Currency Exchange Bonds (FCEBs) that offered Indian companies an additional avenue to raise finances from overseas. We had discussed the implications of FCEBs in a post at that time.

Now, the RBI has issued a circular operationalising the scheme paving the way for issuance of FCEBs. One issue that immediately commands attention is the minimum pricing for these bonds, which continue to follow the formula of the higher of (i) the average of the weekly high and low closing prices of the shares during the last 6 months and (ii) the average weekly high and low closing prices of the shares during the last 2 weeks. In declining market conditions as we have currently been witnessing, this can be an obstacle to the issue of instruments such as FCEBs.

On a separate matter, although relaxations have been made from minimum pricing norms in the case of qualified institutional placements, these restrictions continue to operate (at least as of now) in the case of FCCBs and FCEBs. For a discussion on current implications of the minimum pricing norms, see this discussion on MoneyControl.

The Reserve Bank of India has issued, vide its circular dated 23rd September 2008, comprehensive and updated directions to auditors of non-banking financial companies (NBFCs) (postedhere on the Reserve Bank of India website) requiring them to specifically answer many questions relating to NBFCs. These 2008 Directions replace the decade old 1998 Directions to auditors.

The Directions are in a way unique since they require that any negative or qualified answer should be specifically and directly be reported to the Reserve Bank of India. Normally, the Auditors report to the NBFC.

While there are many specific questions relating to many aspects of NBFCs and compliance of various provisions under the Reserve Bank of India Act and Directions issued thereunder by the Reserve Bank of India, for most practical purposes, the Auditors have to report even if there is a single violation of any of these legal provisions.

While I will write here a more detailed analysis of specific requirement of these Directions in a day or two, it can easily be seen that the Reserve Bank of India has placed much of the burden of interpreting many controversial and ambiguous requirements. This was true under the 1998 Directions too but the 2008 Directions are even more comprehensive. The Auditors will be damned if they interpret in one way and damned too if they interpret the other. For example, the law as to whether a company is an NBFC or not itself is ambiguous with Reserve Bank of India having not issued any clear cut official guidelines. However, the Auditor will have to interpret whether a company is an NBFC or not.

The violations of provisions relating to NBFCs can attract very serious consequences including minimum imprisonment of one year for some violations.

Note though that these directions will NOT apply to the audit for the year ended on 31st March 2008. They apply only to audit in respect of years ending on or after 18th September 2008. However, to view the matter in another sense, they would have immediate and even retrospective effect since they would apply to the current financial year also and though there do not appear to be any fresh requirement on the company itself, the company may need to prepare appropriate records for the auditors for the period from 1st April 2008 to satisfy the auditor that there is due compliance.

A review of these more comprehensive Directions should be made by the NBFCs and their Auditors.

Tuesday, September 23, 2008

RBI has allowed infrastructure companies to raise external commercial borrowings (ECB) under the automatic route up to a maximum of US$ 500 million (compared to the erstwhile limit of US$ 100 million).

Monday, September 22, 2008

An interesting column in the Economic Times by Swaminathan S. Anklesaria Aiyar looks at the biggest government takeovers in history:

“Socialists, like Hugo Chavez in Venezuela or Indira Gandhi in India, are famous for nationalising the biggest corporations. But the US government has taken over three of its biggest corporations within two weeks. Has the US turned socialist?

American right-wingers moan that this is indeed the case. Meanwhile, Indian leftists are stunned at nationalisation in a country they view as pitilessly capitalist.

Two of the nationalised corporations, Fannie May and Freddie Mac, are by far the biggest mortgage lenders in the world, with $5 trillion of mortgages and loans on their books. That's five times India's GDP, to put their size in perspective. The third corporation , AIG, is the biggest insurance company in the world. No nationalisation in professedly socialist countries were ever so big.…

The usual procedure in a capitalist welfare state is to let mismanaged companies go bust, penalising the shareholders and managers, and then provide safety nets to those adversely affected. But when corporations are so large that their collapse would endanger the entire financial system, it's sensible even from a capitalist viewpoint to have a government takeover before they collapse . This is a sort of pre-emptive safety net. Moreover, preventing distress wins votes (or at least doesn't lose them), and that's vital in a democracy.”

The column however concludes that this is not similar to nationalisations as they occurred in the socialist contexts:

“The US takeovers, by contrast, are temporary affairs, to be followed by re-privatisation once the crisis is resolved. The corporations will be obliged to sell chunks of their assets to pay off debts and attain stability. They will then be re-privatised. They will emerge greatly shrunken, and perhaps broken into smaller units.

Nationalisation is a misleading word for this process. It is better called forced restructuring by the government, as a pre-emptive safety net. It aims to save citizens from pain, but within a market economy framework.”

In two previous posts (here and here), we discussed the several corporate governance issues that have been accentuated on account of the current financial turmoil emanating from the U.S. In this post, we examine some of the differences between corporate structures and governance in the U.S. and India.

In India, companies predominantly display concentrated shareholding structures (as opposed to the diffused shareholding structures in the U.S.). Most Indian companies have a controlling shareholder (or group of shareholders). These controlling shareholders take various forms. Most of them are business families. In fact, it has been stated that a “glance at India’s 500 most valuable companies, that together account for over 90% of the market capitalisation of the Bombay Stock Exchange, reveals that about two-thirds of them are part of conglomerates or “business groups””. Others controlling shareholders are the Government itself, as in the case of public sector undertakings, and yet others are multinational companies who own controlling stakes in their Indian listed subsidiaries or affiliates. On the other hand, there are hardly a few companies listed in India that do not have a shareholder or group exercising control over the company.

This concept of a controlling shareholder is further reinforced by the Indian legal regime as well. For instance, the concept of a “promoter” that is prevalent in various Indian regulations does just that. Although the immediate relevance of a “promoter” appears when a company is accessing the capital markets through a public offering in terms of the SEBI (Disclosure and Investor Protection) Guidelines, 2000 or is making an offer (or seeking an exemption) under the SEBI Takeover Regulations, 1997, the concept has wider implications. It demonstrates that the “promoter” has certain legal connotations or attributes that are different from that of other shareholders generally, and hence such promoters undertake an additional role not just as a legal matter but in an overall sense in relation to the control and governance of a company.

What then is the relevance of concentrated shareholding in the context of governance of companies in India? We now turn to the corporate governance factors discussed in the previous post in the background of the financial crisis that originated in the US:

1. No Separation of Ownership and Control

In India, controlling shareholders do have a say in the management and control of the company. Often, controlling shareholders themselves are managers. Alternatively, and by virtue of their shareholding, they do possess the power to appoint their own representatives as managers. Due to their controlling stake, they take a greater role in assessing the performance of the company and usually are on top of the situation as active (as opposed to passive) investors. It is arguable that such direct oversight by controlling shareholders benefits all investors. In other words, what is good for the controlling shareholders is good for the other minority shareholders as well, whose value is likely to be preserved due to the oversight by the controlling shareholders. The problems arising from the separation of ownership and control ought not to appear here.

2. Lack of Director Primacy or Managerial Superiority

Unlike in the U.S., Indian boards are amenable to the wishes of the shareholders. Directors can be appointed and even removed, all through a simple majority as these decisions are required to be taken merely by ordinary resolutions at a shareholders’ meeting. Where directors or senior management do not show performance, they are liable to be removed by the controlling shareholders. This ensures that there is absence of self-perpetuation on the part of the incumbent board and managers.

3. Managerial Pay

The remuneration of directors and senior managers in Indian companies are not comparable to the kind of stratospheric proportions witnessed in the U.S., although Indian pay-scales at the top echelons have seen a steady increase over the years. However, one key difference in India (at least in theory) is that senior management’s pay is subject to shareholders’ approval and also to certain maximum limits in view of Sections 309 and 198 of the Companies Act, 1956. To that extent, shareholders do have a “say on pay” that is mandated by law, unlike in other markets (such as the U.S.) where the decision is largely left in the hands of the boards of directors or their compensation committees.

4. Board Oversight

Unlike the U.S. boards which place a lot of emphasis on board independence, Indian boards consists of a mix of inside directors (such as representatives of the promoters) and outside directors (such as independent directors). This is likely to ensure greater discussion and participation on boards as compared to boards which are loaded with independent directors who tend not to have adequate information so as to participate effectively, and this is especially so during periods of crises as currently witnessed by several U.S. financial institutions.

5. Chairman and CEO

On this count, neither the U.S. nor India mandatorily require a separation of the position of Chairman and CEO. However, in practice, it is found that more Indian companies follow the separation than do the U.S. companies. Hence, in the Indian context, non-executive chairmen of several companies do play a significant role in stimulating more open discussions on boards and also acting as a check on the management of the company (such as the CEO/managing director and other senior managers).

The purpose of this post is to identify some of these key differences in the Indian context that may potentially forestall similar crises in Indian companies, mainly due to the absence of separation of ownership and control. However, it is a different matter altogether that the Indian ownership and governance structures are not necessarily optimal as they often tend to favour the controlling shareholder (such as business families, the Government or multinational) over the interests of minority shareholders, but we shall leave that for another day.

Sunday, September 21, 2008

In the background of the boardroom failures discussed in the previous post, it is useful to explore some of the factors involving U.S. corporate governance that may have led to this situation.

1. Dispersed Shareholding and Lack of Oversight

One of the key problems involving a dispersed shareholding model (that is prevalent largely in the U.S. and U.K.) is that the individual shareholders have relatively small stakes in companies and these do not provide sufficient incentives for them to come together and form coalitions to effectively oversee the managers of companies. This is otherwise known as the collective action problem, which results in a separation of ownership and control. While the shareholders are owners of the company, the control of the company is vested with the managers, as shareholders are unable to participate in decision-making. That gives managers a freehand in the way they manage companies without substantial oversight from shareholders.

2. Director Primacy and Managerial Superiority

Due to the problems discussed above, managers are not only in a position to control the business policies of the company, but effectively also the composition of the board itself. Shareholders usually vote on a slate of directors provided by management. Due to embedded provisions such as staggered boards and poison pills, it is difficult for shareholders (or even hostile raiders) to unseat the incumbent boards and management. All this enables self-perpetuation of management with little fear of being overthrown even in the wake of dismal performance. For these reasons, although the U.S. model of corporate governance is known as the “shareholder model”, in reality there is very little that shareholders can do to constrain managerial misdeeds.

3. Pay Without Performance

Excessive managerial influence also extends to fixing managers’ own remuneration. In a book titled Pay without Performance: The Unfulfilled Promise of executive Compensation, Professors Lucian Bebchuk and Jesse Fried state that managerial influence can lead to inefficient arrangements and perverse incentives in fixing managerial remuneration that make the amount and performance-insensitivity of pay less transparent. These have resulted in CEOs and other senior officers of large U.S. corporates being paid colossal sums of money that do not necessarily correlate with the performance of the company or the value created (or destroyed) for shareholders. Golden parachute arrangements ensure that CEOs obtain large payments even when their services are terminated for poor performance. As Nell Minow notes:

“I am a capitalist. I love it when executives earn boatloads of money. But it infuriates me when they get it without earning it.

If the executives' compensation is tied to the volume of business rather than the quality of business, we should expect dealmakers to be more attentive to the number of transactions than the value they create. This is the basis for much of the sub-prime mess, whose collateral damage is taking down the biggest firms on Wall Street.…

The boards of directors approved pay that was completely disconnected to performance. This, after all, is the world of the ultimate oxymoron: the "guaranteed bonus." So we should not be surprised that executives took the money and ran.

Fewer than 13 percent of public companies have claw-back policies requiring executives to return bonuses based on inflated numbers. All of the incentives are for them to inflate the numbers, take the money, and run.

And that is why companies whose names used to be synonymous with stability and trustworthiness will live on through history and business school case studies as discredited, greedy and corrupt.”

Such arrangements for pay, whether in the form of salary, bonus or even stock options encourages short-termism that incentivizes managers to boost short-term profits of their companies and earn large sums of moneys, but at the cost of the interests of shareholders that tends to be relatively longer term. This mismatch of expectations and incentives makes managers take decisions that may in the end cause their downfall as we have seen in the recent failures.

What is even more troublesome is the fact that remuneration of directors and senior managers is fixed by the board (or compensation committee), with no approval required from shareholders for fixing such remuneration. In other words, shareholders have no “say on pay” that is mandated by law, although there are proposals on the cards for requiring shareholder approval (at least on a non-binding basis).

4. Lack of Responsiveness on the Part of Boards

Leading shareholder activist, Carl Icahn, notes on his Blog, The Icahn Report:

In each case, the root cause seems to be excessive risk-taking by managements, or worse, managements that weren’t sufficiently aware of the risks their companies were taking and how it may impact their businesses.

Who was supposed to be watching these managers? Where were the boards of directors that are supposed to be overseeing these executives? I’m not going to judge the individual boards of these companies in what they did or should have done, but consider the following.

All too often compliant boards are intimidated by managements in their cushy, well-paid worlds and refuse to rock the boat by asking hard questions and demanding CEO accountability. Why is this so? Because of excessive board compensation and allegiances to those who provide it.”

That leads to the issue of who were the individuals that were on the boards of these companies. Obviously, many of them were independent directors. The Financial Times has an interesting report that discusses the composition of the Lehman board:

“At a time when the financial markets’ complexity is mind-boggling even to those who work a 80-hour week on Wall Street, nine of Lehman’s 10 external board members are retired.

Lehman’s five-member finance and risk committee, which reviewed the bank’s financial policies and practices, is chaired by Henry Kaufman, the respected former Salomon Brothers economist. But Roger Berlind, a board member for 23 years, left the brokerage business decades ago to produce Broadway plays.

Another director, Marsha Johnson Evans, is a former chief of the American Red Cross and the Girl Scouts. Jerry Grundhofer, the former US Bancorp chief executive, is the only Lehman external director who has recently run a bank. But he did not sit on any board committees.

“This was not the strongest board for a company this size – in terms of age and in terms of people who have a toe in the water,” said one senior Lehman employee.”

Surely, these were highly accomplished individuals, but were they suited for the job is a different question altogether. Board independence does not seem to have instilled a strong level of monitoring on such boards.

5. Combined Roles of Chairman and CEO

Even the seeming onerous provisions of the Sarbanes-Oxley Act have failed to address one key issue: there is no mandatory separation of the Chairman and CEO on U.S. corporate boards. Most companies still have the same individual occupying the post of the Chairman and CEO. That puts such individual in a powerful position, which allows for little transparency into such individual’s acts, as they can go unmonitored until they reach irreversible proportions. On the other hand, separation of these roles and having two separate individuals serve as Chairman and CEO allows the chair to serve as a check on the CEO, thereby providing checks and balances that result in better shareholder value. Although other jurisdictions such as the U.K. have been long practising the separation of these roles, this is not mandated in the U.S., and despite several calls from corporate activists for such separation, that has not received due attention yet.

These are some of the plausible reasons for governance failures in the U.S. in the recent financial crisis. In a subsequent post, we will compare and contrast some of these governance issues as they apply in the Indian context.

Saturday, September 20, 2008

Much has already been stated in the press about the current financial crisis that has rocked not only the U.S. economy, but also the global financial system, and indeed the magnitude of this crisis will ensure that a lot more will be said in the future. Here we focus on one aspect of the crisis, which is the perceptible failure of corporate governance involving large companies.

In a provocatively titled book The End of History and the Last Man, Francis Fukuyama argues that the advent of Western liberal democracy may signal the end point of mankind’s ideological evolution and the final form of human government. But, of immediate interest to us is a debate in corporate governance that takes a leaf out of Fukuyama’s book (or at least its title to begin with). In an article, The End of History for Corporate Law, two leading U.S. corporate law professors, Hansmann and Kraakman set the framework for the current global corporate governance debate, where their argument is twofold: (1) American corporate governance has reached an optimally efficient endpoint by adopting the shareholder primacy and dispersed shareholding corporate model, and (2) the rest of the world will inevitably follow, resulting in a convergence of corporate governance around the world on the lines of the U.S. model. Although these arguments have been subject to a fair amount of criticism, events that have occurred over the last few days severely expose chinks in the U.S. model of corporate governance, and provide at least some anecdotal evidence that such model is not infallible after all.

The question that is being posed is: where was corporate governance when the CEOs and boards of directors of large and admired U.S. corporations such as Bear Stearns, Lehman Brothers, Freddie Mac, Fannie Mae, Merrill Lynch and AIG saw the performance of their companies plummet, which finally resulted in a massive erosion of value to their shareholders and other stakeholders? Going back into (recent) history, this is indeed not the first time that such questions have been posed. Earlier at the turn of this century, we saw the very same questions being asked when a governance crisis of a slightly different nature occurred with Enron, WorldCom, Tyco and other companies being mired in accounting scandals.

Following this, stern legislative measures were introduced in the U.S. in the form of the Sarbanes-Oxley Act of 2002 that required companies listed in the U.S. to put in place strong systems and practices to enhance corporate governance. However, those measures apparently have been insufficient to deal with the current crisis.

Nell Minow, an influential corporate governance activist and commentator has this to say in a column on the CNN website:

“Despite the post-Enron adoption of the most extensive protections since the New Deal, a survey released this week by Kroll and the Economist Intelligence Unit found that corporate fraud rose 22 percent since last year.

The option back-dating and sub-prime messes show that even the post-Enron Sarbanes-Oxley reform law and expanded enforcement and oversight cannot eliminate the severest threats to our markets and our economy.

This proves that there are limits to structural solutions. Ultimately, markets are smarter and more efficient than regulation. What the government needs to do now is insist on removing obstacles to the efficient operation of market oversight.”

That being said, it must be noted that the Enron cohort of scandals involved some element of fraudulent conduct on the part of the actors involved (that included both insiders such as the board and managers as well as outside gatekeepers such as auditors), while in the current situation there has been no such allegation or finding yet, with the situation arising mostly from misjudgments in valuing complex financial instruments and transactions that these companies either invested in or became involved with.

In a few following posts, we will explore some of the factors involving U.S. corporate governance that may have triggered this situation, and also see how the Indian corporate governance structure and framework are somewhat different with arguably greater capability to prevent and deal with such crises.

The new proposal to deal with the financial crisis involves the U.S. Government setting up a special fund to acquire toxic or illiquid financial assets on bank balance sheets. The Times Online has a report:

“Henry Paulson, the US Treasury Secretary, hopes to nationalise the global risks associated with America’s sub-prime mortgages by setting up a toxic relief fund to buy up the mortgage assets that are poisoning banks’ balance sheets and sowing the widespread distrust that has prevented banks from lending to each other. Although the assets involved and the pricing of them will be much more complicated, the nearest equivalent is the Resolution Trust Corporation. This operated from 1989 to 1995 to buy up the toxic paper of almost 800 banks which failed in the US Savings & Loans crisis.”

Such a fund appears similar to the asset reconstruction companies (ARCs) that have been set up in India in the last 5 to 6 years for acquiring non-performing assets. The Indian ARCs are left with the task of acquiring mostly plain-vanilla financial assets such as loans, bonds, leases, while this new entity in the U.S. will have the more onerous task of acquiring complex financial instruments that have arisen through securitisation, collateralised debt obligations, derivatives and the like (that now suffer the ignominy of being alluded to as “toxic” assets). The key problem there is the issue of valuation as these assets are essentially illiquid and hence incapable of precise valuation. Such issue has no easy solution, as breakingviews.com notes:

“The list of questions is daunting. What assets should be considered toxic or illiquid? How should they be valued – implicit market prices from earlier this week, from just before Lehman Brothers collapsed, or something still higher? The higher the assets are valued, the bigger the costs to the taxpayer; the more they are valued in line with current conditions, the less it will help.

Then there’s the matter of who will participate. Can hedge funds, private equity houses and institutional investors? And how will the government detoxify its new portfolio? Who on earth can be trusted to run it?

Perhaps the intelligence and skill which went to create all these infectious instruments can be turned to unwinding them. But it’s almost inevitable that the most irresponsible market players will end up getting the greatest relief.”

(Update – September 21, 2008: The details of the Rescue Plan are now available, with the Government committing a maximum of $700 billion for the purchase of mortgage-related assets.)

Due to allegations that the stock price of several financial institutions involved in the current crisis were beaten down by short sellers, several jurisdictions have recently introduced greater curbs on short selling.

The U.S. Securities and Exchange Commission (SEC) has introduced temporary bans on short selling in securities of 799 financial companies (see this report on the Harvard Law School Corporate Governance Blog). Other jurisdictions such as the U.K., through its Financial Services Authority (FSA), and Australia have introduced restrictions on short selling (see this report on the Corporate Law and Governance Blog).

While these measures are desirable, there exists strong opinion in some quarters that these are too little, too late.

(For a previous discussion on the concept of short selling and how it affects stock markets, please see an earlier post on this Blog)

The Government has liberalised the policy for foreign print media, which now allows foreign news and current affairs magazines to publish Indian editions. This will allow Indian readers to access these magazines at more affordable rates. LiveMint has a report:

“India has decided to allow the publication of local editions of foreign news and current affairs magazines, lowering a significant hurdle to entry of more foreign news media into the country.

The changes, announced by the Indian cabinet, reiterated the 26% cap on foreign direct investment into Indian news print ventures.

But, the latest relaxation means that news magazines such as Time, Newsweek, The Economist or BusinessWeek, can now enter into an agreement with an Indian publisher to publish cheaper Indian editions with up to 100% foreign content, and to sell advertising in India for the publication. There were major restrictions on both those fronts until now.

The new policy retains significant content and advertising restrictions on foreign newspaper ventures in India, continuing a policy of discriminating in favour of television news and, now, news magazines over newspapers.”

Wednesday, September 17, 2008

(In the following post, Venugopal Mahapatra and Gautam Bhatia discuss the Indian legal position regarding non-compete and non-disclosure clauses in employment and similar contracts in the context of a Bombay High Court decision. They also compare and contrast the Indian law on this topic with the position that prevails in the U.K.)

V.F.S. Global Services Ltd. v. Mr. Suprit Roy is a December 2007 decision of the Bombay High Court. It is notable for some interesting observations of the Court upon the matters of restraint of trade and protection of trade secrets.

The controversy arose because of a condition in the contract of employment between the company and the employee whereby the employee was not permitted to participate with any other company carrying on similar business, and was also restrained from commencing similar business during the period of employment or for a period of two years after. Subsequently, a covenant of confidentiality was entered into by the parties, whereby the employee was not permitted to disclose or make use of any confidential information of the company, whether during the period of employment or after, except under certain special circumstances; and also that in the event he left service, or was terminated from service, he would not enter into the service of any employer who had a conflict of interest with the business of the plaintiff. Finally, there was a review of these conditions, and the insertion of a “Garden Leave Clause,” whereby the company, among other things, reserved the right to require the employee to remain away from work or employment after termination or resignation, and to comply with the conditions laid down by the company at such time.

In the instant case, the plea was for enforcement of this negative covenant. The Court first examined the Garden Leave Clause. It observed that the clause intended to operate after the cessation of employment. On this ground the defendant (employee), citing a number of previous judgments, had pleaded that it violated Section 27 of the Indian Contract Act, and was therefore void. The Court, following the seminal case of Niranjan Shankar Golikari, drew a distinction between a restrictive condition in a contract of employment which was operative during the period of employment and one which was to operate after the termination of the employment. The latter amounted to restraint of trade, while the former did not. On this basis, the Court held that the Garden Leave Clause was hit by Section 27, observing that neither the principle of reasonableness of restraint, nor the fact that the restraint was partial, was of any relevance.

At this point, it would be instructive to briefly discuss the position of Indian law with regard to negative employment covenants and restraint of trade. Indian law underwent a well-marked departure from the common law jurisprudence following the apex Court ruling in Krishna Murgai. The Supreme Court, giving an extremely narrow construction to Section 27 of the Indian Contract Act (which deals with restraint of trade), firmly rejected the importing of the common law doctrine of ‘reasonability’. In the recent high-profile cases involving Indian Cricketing superstars Zaheer Khan and Yuvraj Singh, the apex Court reaffirmed the strict construction of Section 27 and struck down the ‘right of first refusal’ clauses which were due to take effect after the end of the contractual period. The UK position, in this regard, allows for post-service covenants provided they are reasonable as to time, market and geographical limits. However, Indian law provides for no such scope, and validates only those agreements which are necessary for protection of ‘goodwill’. Thus, in the V.F.S. Case, the Bombay High Court toed the line drawn by the apex Court.

The Court then examined the contentions based on the agreement of confidentiality. The Court held, straightforwardly enough, that a clause prohibiting an employee from disclosing commercial or trade secrets was not in restraint of trade, as the effect of such a clause was not to restrain the employee from exercising a lawful profession, trade or business within the meaning of Section 27 of the Contract Act. It rejected the defendant’s contention that the exact nature and scope of the confidential information had not been precisely defined.

At this juncture, it is again pertinent to cast a glance at the UK’s legal position on the aspect of confidential information. After the landmark case of Faccenda Chicken, information is graded into 3 tiers. The first tier includes information which is already in the public domain and could be used by the employees post-service. The second tier covers confidential information which the employee cannot use or disclose during the period of employment without breaching his duty of fidelity to his employer, but which, in the absence of an express non-disclosure term, could be used post-service. The third tier includes only specific trade secrets which the employee cannot disclose or use during or after employment even in the absence of an express non-disclosure agreement. Thus, the law balances the interests of employers by preserving confidential information and trade secrets on one hand and those of the employees by protecting their ‘skills’ and assets. The decision in V.F.S., while pointing to the need for protecting trade secrets, goes no further. It is submitted that it is essential to incorporate such guidelines in Indian law to ensure clarity and predictability.

Thus, though the Indian position on this aspect has been consistent, it has nevertheless witnessed strong criticism on more than one count. While the Bombay High Court pronouncement introduces much needed protection to trade secrets by taking it out of the ambit of restraint of trade, nevertheless much ground needs to be covered in order to ensure security to trade secrets. In V.F.S., the Court had the chance to do just this, as the defendant expressly pleaded that the nature of the confidential information was vague and so could not be sustained; however, this plea was rejected. Therefore, it is submitted that V.F.S. is an important step in this regard, but needs to be developed further, with the U.K. position being a possible model.

Tuesday, September 16, 2008

Recently, the Revenue Department issued a guideline to the Foreign Revenue Investment Board [hereinafter “FIPB”], instructing them to reject foreign direct investment in the telecom sector from companies based in tax havens. The issue arose when Daltotrade Ltd., a Cyprus-based company, tried to raise its stake in Meta Telecomm, an Indian company. Under the India-Cyprus DTAA, Cyprus residents are exempt from capital gains tax in India, and the Cyprus laws do not impose any such capital gains tax. This enables double avoidance of taxation, which is something the Department seeks to avoid, which is why there is talk of the DTAA being amended accordingly. However, the fact that DTAAs with other countries like Mauritius have similar provisions makes this a larger issue than merely the DTAA with Cyprus. The issue here basically revolves around the meaning of ‘resident’ under a DTAA. The usual definition of resident in Indian DTAAs and under the Model Laws is: ‘For the purposes of this Agreement, the term ‘resident of a Contracting State’ means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation or any other criterion of a similar nature.’ Apart from the meaning of the terms ‘domicile’, ‘residence’, ‘place of management’ and ‘place of incorporation’, the more significant qualifying term in this definition is the phrase ‘liable to tax’. Even if one of the other four terms are satisfied, on a plain reading of the provision, it would not suffice, unless the satisfaction of the terms made the assessee ‘liable to tax’ in the Contracting State. However, there is a great degree of confusion as to the meaning of ‘liable to tax’. Logically, there are three possibilities: A person may not be covered by the tax net of a country (for instance, the U.A.E. does not tax individuals); the person may be covered by the law, but may enjoy an exemption is respect of certain income; and the person may be covered and be paying taxes under the law of that country. Which of these three cases does the term ‘liable to tax’ refer to? There seems to be a fair degree of judicial disagreement on this point, succinctly summarised by a reading of two conflicting decisions of the AAR in In re Mohsinally Alimohammed Rafik (1994) and Cyril Eugene Pereira v. C.I.T. (1999), and the 2003 decision of the Supreme Court in Azadi Bachai Andolan. Rafik endorsed the view that ‘liable to tax’ includes even the first scenario mentioned above. However, Pereira reconsidered this decision and concluded that being subject to tax liability is essential. The landmark decision of the Supreme Court in Azadi Bachao reconsidered these cases, and in conclusion, disagreed with the decision in Pereira. However, the precise nature of this disagreement is unclear. Azadi Bachao dealt with a situation where there was a specific exemption in respect of certain types of income for residents, and not when a certain class of residents was not subject to any sort of tax. Thus, the context was entirely different from that in Pereira, and the disagreement has not been reasoned out either. What makes a debate on this issue relevant today is the fact that, while the recent guideline may seem validated by the decision in Azadi Bachao, it is essential that a misreading of Azadi Bachao, as authority for propositions wider than what it actually said, should not affect decisions in important areas like foreign investment.

Another area where such a misreading is possible is the discussion of the decision on forum-shopping. While there seems to be a widespread belief that the Court gave a clean-chit to forum-shopping, an alternate interpretation of the decision seems equally tenable. The Court only says that a “hypothetical assessment of the ‘real motive’ of the assessee” is irrelevant for the purposes of determining residence. Now, this statement incorporates in it two qualifications: First, it precludes only a hypothetical assessment of real motives, and not a fact-based examination of the same. Thus, this statement would seem to suggest that if, on fact, it is proved that the motive for incorporation was tax evasion alone, it would be sufficient to lift the veil. However, it must be admitted that this interpretation of the statement goes against the general tenor of the decision, and would, in all probability, be incorrect. However, there is a second, and more significant, qualification which the statement definitely allows. Just before discussing the non-examination of motives of the assessee, the Court opined that, “(i)f the Court finds that notwithstanding a series of legal steps taken by an assessee, the intended legal result has not been achieved, the Court might be justified in overlooking the intermediate steps”. This means that if the independent entity has not, in fact, been created, the Court may be entitled to ignore the residence of this independent entity. Now, the corporate veil can also be lifted in cases other than when the creation of the new entity is for the sole purpose of avoiding tax liability. All that the decision in Azadi Bachao seems to do disallow is lifting the veil on the basis of motive for the creation of the entity. However, the decision is not authority for the proposition that the newly created entity will, in all cases, be considered independent, in ignorance of principles of corporate law. Thus, if, on facts, the new entity is considered the agent of the parent, or forms a single economic unit with the parent, the veil may still be lifted. It also seems to permit lifting the veil on grounds of injustice/inequity, which is an accepted basis in India. It is these, and other interesting issues on the interpretation of DTAAs that are discussed by Mr. Sohrab E. Dastur in his recent piece. Apart from the two topics detailed above, he also sheds considerable light on issues like the effect of amendments to the Income Tax Act on the interpretation of a pre-existing DTAA, or amendments to a DTAA on pre-existing contractual arrangements. The article also contains a detailed exposition of the relation between the DTAA and the Income Tax Act, and the principles of interpreting tax treaties, providing an interesting insight into this fast-emerging area of law, with enormous commercial significance.

The article is available at http://www.itatonline.org/interpretation/interpretation17.php.

In the short span of a decade that the Arbitration and Conciliation Act has been in force, the Supreme Court has gradually carved for itself a wider and wider role in various stages of arbitration proceedings. Its role in the appointment of arbitrators, granting interim injunctions and reviewing arbitral awards on grounds of public policy are a few examples.

Its 2002 decision in Bhatia International effectively extended the applicability of several provisions of Part I of the Arbitration Act to international commercial arbitrations outside India. An earlier post noted that in 2008, the Court further extended the Bhatia reasoning, and chose to even review foreign arbitral awards. This trend has been strengthened with a recent decision in INDTEL Technical Services v. WS Atkins PLC (Arbitration Application No. 16 of 2006, decided on 25 August, 2008).

This decision is noteworthy not just for its adherence to Bhatia, but for its decision to allow an Indian company to invoke the Indian Arbitration Act against a foreign company under a contract that was governed by foreign law. INDTEL had entered into a Memorandum of Understanding with WS Atkins PLC, and submitted a joint tender for an Indian Railways Crashworthiness Project. Before a decision could be made on the tender, Atkins withdrew the joint bid and terminated the MoU. The MoU expressly designated English law, providing that “this Agreement, its construction, validity, and performance shall be governed by and constructed in accordance with the laws of England and Wales”.However, when requests for compensation failed, INDTEL filed an application under Section 11 of the Arbitration Act, seeking the appointment of an arbitrator to settle the dispute. The question before the Court was whether this was maintainable in view of the designation of English law, and whether its decision in Bhatia could be extended to cover a situation of this sort.

The Court held that it could. In Bhatia, it had held that Part I of the Act applied to international arbitrations outside India unless there was a specific provision to the contrary. In Venture Global, it had extended this reasoning and held that a foreign arbitral award could be tested by a domestic court on public policy grounds. In this case, Atkins sought to distinguish these decisions by suggesting that the “specific provision to the contrary” did exist, in the form of the designation of a specific system of law as the applicable law.The Court rejected this suggestion, holding that what is required is not just the designation of a specific system of “substantive” law, but of “arbitration law”. In other words, unless the contract either excludes the applicability of the Indian Arbitration Act, or specifies a foreign Arbitration Act as applicable, the Indian Act will be held to apply. Interestingly, in a 1992 decision (NTPC v. Singer, (1992) 3 SCC 551), the substantive law had been specified as Indian law, but the contract was silent on the applicable arbitration law. The Court had held there that Indian arbitration law applied as a matter of presumption. The law on this aspect is therefore unclear today, although it is possible to reconcile these decisions on the basis of the content of the agreements in question.

While the decision may be open to criticism for its interpretation of the Act, it does have the merit of certainty, since it is now clear that a contract will deprive Indian courts of jurisdiction in respect of arbitration matters only if it satisfies one of the two criteria outlined above. This decision is therefore likely to be welcomed and criticised in equal measure.

Monday, September 15, 2008

Last week the Economic Times reported here that listed companies would soon have to increase their public shareholding levels – possibly by 3 – 5% annually until they become compliant with continuous listing requirements.

Whether the minimum public float should be 25% or 20% is a matter of policy wisdom. The law always has to draw a line somewhere and treat people on either side of the line evenly. The key is to make people aware of the law and to ensure that one who has conducted oneself on the basis of known law is not jeopardized under a new law.

Laws can always change. However, when a law is changed, people used to working under the old law ought to get adequate time to re-arrange affairs to remain compliant even under the new law.

The minimum level of public shareholding has remained a tricky area of regulation. Growing Indian companies are dynamic and their public shareholding cannot be expected to stagnate. Mergers, strategic and private equity investments, and stock-funded acquisitions could always lead to shrinkage in public shareholding. So long as the level of public float does not hamper traded volumes and thereby price discovery for the stock in the market, a more “lenient” yardstick may also be applied – such thinking is what led to the current regime of permitting a 10% public float for companies having a market cap of Rs. 1,000 crores and at least two crore issued shares.

Tied into this regime would be the framework for delisting companies. The term “delisting” has come to represent anathema for Indian regulators. The law should clearly lay down the level of shrinkage in public shareholding that would be needed for a delisting effort to be successful. Even if the lawmakers do not think the line drawn for continuous listing requirements should also work for successful delisting, they owe it to the system to transparently draw another line for declaring a delisting effort to be successful, and also specify what one needs to do when leading life in between these two lines.

Sunday, September 14, 2008

Generally, the gains arising from a demerger are exempt from capital gains tax, while those arising from a slump sale are not. But, then, what exactly is a ‘demerger’ for the purposes of the exemption from capital gains tax? Can a demerger ever be characterized as a ‘slump sale’? Several sections of the Income Tax Act, 1961 deal with these issues.

The statutory provisions in the Income Tax Act:

A. Section 2(19AA) says that a ‘demerger’ means a transfer pursuant to a scheme under Sections 391-394 of the Companies Act, 1956 (by a demerged company of its one or more undertakings to any resulting company) such that a list of seven conditions enumerated in separate clauses is fulfilled. Clause [iv] is particularly relevant for the present discussion. It says that the resulting company must issue, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis.

B. A slump sale is defined in Section 2(42C) to mean the transfer of one or more undertakings as a result of the sale for a lump-sum consideration without values being assigned to independent assets and liabilities.

C. According to Section 45, any profits or gains arising from the transfer of a capital asset are chargeable to capital gains tax.

D. Under Section 47(vii), the provisions of Section 45 do not apply to a transfer in a demerger of a capital asset by the demerged company to a resulting company if the resulting company is an Indian company.

E. Under Section 50-B, capital gains arising from slump sales are chargeable to tax. The capital gains from such slum sales are to be calculated by subtracting the net worth of the undertaking that is transferred from the lump-sum consideration (as per Explanations 1 and 2 to the Section).

In short, if a transfer is a demerger under the Income Tax Act, capital gains liability would not arise. If it is a slump sale, such liability would arise. For the transfer to be a ‘demerger’, the conditions mentioned in Section 2(19AA) must be complied with. But what happens when one or more of the conditions are irrelevant to a particular transaction? How this may happen is exemplified by the facts of the complex case of Avaya Global Connect v. ACIT, ITA No.832/Mum/07 (the judgment is available on the website of the Mumbai ITAT Bar Association at http://itatonline.org/archives/?p=118).

The Facts:

The assessee ‘A’ was a company having two divisions – ‘B’ and ‘T’. ‘T’ was transferred by ‘A’ to ‘I’, an Indian company. For this transfer, a scheme of arrangement filed before the Bombay High Court provided, “… ‘T’ without any further act, instrument or deed… shall stand vested in or deemed to be vested in ‘I’ as a going concern…” Significantly, the scheme went on to say “Upon the demerger of ‘T’ into ‘I’, ‘I’ would not pay consideration either to ‘A’ or to the shareholders of ‘A’…” (Emphasis supplied.) The Bombay High Court sanctioned this scheme. The value of the assets taken over by ‘I’ was less than the value of the liabilities; and ‘A’ showed the difference in the capital reserve account in the balance sheet. A question arose as to whether the gains which accrued to the assessee (as it had transferred more liabilities than assets) would be chargeable to capital gains.

The claims:

The Department took the view that the scheme would not qualify as a demerger; on the basis that clause [iv] mentioned above was not satisfied. The assessee contended that clause [iv] was inapplicable to the case, as the clause would have effect only when there was some consideration for the transfer. In the case, the value of its liabilities exceeded its assets, leading to negative net worth. Therefore, there was no consideration for the transfer – as a practical matter, it was impossible for there to be any consideration. As there was no consideration whatsoever, the question of complying with clause [iv] would not arise. Without prejudice, it was argued by the assessee that the transfer could not have been a slump sale given that no lump-sum consideration was paid. Further, it was contended that there being no sale consideration received in respect of the transfer, no question of computing capital gains arose.

The AO and the CIT (Appeals) however rejected these contentions. It was held that the transaction was a slump sale. The assessee had not received consideration as such; yet it had transferred liabilities in excess of assets and had credited the difference to its capital reserve account. This was sufficient to constitute consideration received on account of the transfer; and the assessee was liable to pay capital gains tax.

The issues before the Tribunal:

Essentially, the Tribunal faced the following questions:

A. Was the transfer to be characterized as a ‘demerger’ for the purposes of the Income Tax Act, 1961?

B. If not, could it be referred to as a slump sale? If it was a slump sale, would there be any capital gain on facts (considering the negative net worth of the assessee and the fact that no actual consideration was received)?

C. What would be the position if the transfer was categorized as neither a demerger nor a slump sale?

The decision:

A. The Tribunal agreed with the lower authorities that there was no ‘demerger’ in the present case. It was held that the legislature must be presumed to have foreseen all practical possibilities while adding the conditions. The fact that there was no consideration whatsoever (as a matter of practical impossibility) would not be sufficient to hold that the condition was inapplicable.

B. The Tribunal then went on to hold that it is only a transfer as a result of a sale which can be considered as a slump sale. The presence of a money consideration is essential for a sale. Also, when a Court sanctions a scheme under the Companies Act, the transfer in pursuance of that scheme would be not be a result of sale, but would be a result of the operation of law.

C. Essentially, the capital asset which was transferred in the case was a going concern. It would not be possible to “… conceptualize the cost of acquisition of … a going concern (or) the date of acquisition thereof…” As such, it was held that the computation provisions of the Act in Section 48 would fail in the given factual matrix. In such a scenario, no capital gains could be levied. Accordingly, the assessee’s appeal was allowed.

The significance:

From the point of view of the corporate world, the judgment serves to highlight an important point. Merely because a transfer is carried out in accordance with a scheme for a demerger under the Companies Act sanctioned by the competent High Court, the transfer will not be characterized as a demerger for the purposes of taxation. At the same time, such a transfer will not be a slump sale; and liability to capital gains will depend on whether or not the provisions for computation of capital gains would be workable. The safer course, it appears, would be to ensure that the requirements for a demerger under tax laws are complied with in the first place.

Saturday, September 13, 2008

Under the present provisions of Sections 391-394 of the Companies Act, 1956 it is possible for a foreign company to merge with an Indian company, but an Indian company cannot be merged with a foreign company. This is intended to ensure that the company that continues after the merger is an Indian company over which the Indian regulatory authorities continue to exercise control. Although there was some speculation that the proposed Companies Bill will alter this position and make it possible for Indian companies to merge into foreign companies, that seems to have been put to rest with the Government possibly preferring a status quo, as this report in the Economic Times suggests:

“The government has decided not to allow the merger of Indian companies with foreign companies, a proposal it deliberated on extensively while formulating the new company law.

Although this is an international best practice in the laws relating to mergers and acquisitions, the government has concluded that merger of an Indian company with a foreign company would lead to a situation where shareholders of the Indian company hold shares or other tradable securities in the foreign company.

Allowing this would amount to the migration of Indian companies to the acquirer’s soil, which the government is not comfortable with. Therefore, an overseas company acquiring an Indian firm will have to keep the acquired company as a subsidiary.

The government, however, is okay with the reverse — that is, foreign companies getting merged with Indian companies and its foreign shareholders owning shares in the merged company which is registered under Indian laws.

Sources said that if a foreign company indeed wants to merge an Indian company with itself, it can first set up a subsidiary in India and then merge the acquired Indian company with the subsidiary. This would ensure that Indian businesses would be owned by entities regulated under Indian corporate law.”

Earlier this week, the World Bank and its investment arm, the International Finance Corporation, published the Doing Business Report 2009. In this report, they rank a total of 181 countries in the world based on “tracking reforms aimed at simplifying business regulations, strengthening property rights, opening up access to credit and enforcing property rights.”

This year, India has been ranked 122, which is two notches below its previous (2008) ranking of 120. A summary of the report on India’s position is available here. There is no cause for celebration as India ranks far below several other emerging economies. In just doing a BRIC comparison, we find that India ranks below China (at 83) and the Russian Federation (at 120) which staying above Brazil (at 125).

In terms of various parameters considered in the rankings, on the positive side, India has shown only one significant improvement, which is in registration of property. On all other counts, it has either stayed in the same position as the previous year, or has gone lower down in the world rankings. In relative terms, India has achieved fairly high scores for getting credit (at 28) and protecting investors (at 38). However, the performance has been dismal in relation to paying taxes (at 169) and enforcing contracts (at 180). As regards enforcement of contracts, India is second from the bottom (only after Timor-Leste). A news report in the Business Standard attributes the lack of efficiency in the legal system as one of the factors for dragging down India’s ranking.

While there is an argument that these reports should not be taken seriously, there is an equally strong view that the adversely affect India’s image and credibility in the global financial markets. Whatever may be the case, this is certainly enough impetus for introspection raising the need for a thorough review of some of the issues that are responsible for the current ranking.

As I had stated last year in response to the rankings released for 2008, there are several issues to be immediately addressed (and these are only indicative and by no means exhaustive):

1. The need for streamlining procedures for carrying on business in India – reduction in number of procedures as well as number of authorities involved.

2. Avoidance of delays in granting approvals and licences that currently takes inordinately long. There is a dire need for cutting down time frames for governmental decisions taking.

3. Inducing transparency in the decision-making process, thereby minimizing the chance for corruption at various echelons of the governmental machinery.

4. Empowering the judiciary with the capacity to absorb contract enforcement tasks and perform them satisfactorily and in a time-bound manner.

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